Internal Funds Allocation and the Ownership Structure: Evidence from Korean Business Groups

We examine the relationship between the controlling shareholder’s cash flow rights and the funds transfer in the internal capital market within Korean business groups (chaebols) during the period from 1998 to 2001. We find that the funds allocation in the firms where controlling shareholders have high cash flow rights is better aligned with the investment opportunities and therefore, more efficient than in the firms where they have low cash flow rights. This effect is stronger when they have controlling powers large enough to expropriate minority shareholders. However, during the financial crisis period, funds simply move toward the firms where controlling shareholders have high cash flow rights. The results evidence the tunneling behavior in the internal capital market within a chaebol that the ownership structure distorts the allocation of internal funds in such a way as to benefit the controlling shareholders.JEL Classification: G31, G30     

Internal capital markets,corporate investment,and the COVID-19 pandemic: Evidence from Korean business groups

This paper examines whether the investment of Korean business group (“chaebol”) affiliated firms behaved differently from that of non-chaebol firms in response to the COVID-19 outbreak. I show that chaebol firms cut back investment to a lesser degree than similar non-chaebol firms. Chaebol firms with higher-than-industry-median market-to-book ratios invested more and experienced less decline in their stock prices, while I do not find such relationships for non-chaebol firms. This paper provides evidence that chaebol internal capital markets helped mitigate the negative effects of the pandemic on firm investment and value.     

The Wealth Effects of Capital Investment Decisions: An Empirical Comparison of Korean Chaebol and Non‐Chaebol Firms

Abstract:   This paper investigates the capital investment decisions of Korean firms and their impact on shareholder wealth. Overall, we find positive abnormal returns surrounding the announcements of 697 cases of investment projects during the period 1992–1999. This paper also finds that the investment decisions of business group ( chaebol ‐affiliated) firms do not increase shareholder wealth, while the capital investment decisions of non‐ chaebol firms generate significantly positive abnormal returns. The multivariate tests provide consistent evidence that the announcement effects for chaebol firms are lower than for non‐ chaebol firms, after growth opportunities, investment size and firm size are controlled for. The findings support the view that the organizational structure of Korean chaebols creates an incentive for managers to make non‐value maximizing capital investment decisions.     

Tax Motivated Income Shifting and Korean Business Groups (Chaebol)

Abstract:  This paper examines tax-induced income shifting behavior among affiliated firms in Korean business groups (chaebols). Korean corporate income tax law does not require consolidated tax returns, and business groups with a large number of affiliated member firms have incentives to shift income across member firms to reduce the overall taxes of the group. For a large number of Korean companies that are subject to external audits, we perform univariate and multivariate regression analyses on the income shifting behavior of chaebol firms compared with non-chaebol control firms. Our evidence suggests that tax-motivated income shifting activities exist among chaebol firms, and that the extent of income shifting is found to depend on its effect on non-tax cost factors such as the earnings, leverage, and cash flow rights of the controlling shareholders. We also find that income shifting is more pronounced in chaebol firms where the control-cash flow divergence is relatively large, suggesting that income shifting is affected by the controlling shareholders' opportunism. Our study provides some insights on the intra-group income shifting activities where research is limited.     

A flight to Q? Firm investment and financing in Korea before and after the 1997 financial crisis

We examine investment behavior among exchange-listed Korean manufacturing firms before and after the 1997 financial crisis using firm-level panel data. Starting with the standard Q-theory of investment, we augment it by allowing for a sales accelerator and the possibility of cash constraints, categorizing firms based on their age, size and affiliation to an industrial conglomerate (i.e., chaebol). We find that Tobin’s Q is a robust determinant of investment in a pooled sample for 1992–2001, but that it became more important for small firms and less important for chaebol-affiliated firms after the crisis. Investment by chaebol firms also became more sensitive to the availability of internal cash balances after the crisis. We interpret this as reflecting a shift in the Korean economy to a stronger market orientation after the crisis and to a business climate in which the quality of potential projects became more important relative to capital market imperfections in determining the destination of investment funds.     

Corporate efficiency,credit status and investment

This paper considers the relationship between financial frictions and investment. In an effort to clarify the role of cash flow in examining the impact of capital market imperfections, endogenous switching regression models are estimated for a panel of 1122 UK firms listed on the London Stock Exchange over the period of 1981–2009. Not only is the financial regime which the firm faces endogenous, we also allow the regime to change over time via modeling efficiency using stochastic frontier analysis. The results reveal that a firm's constrained credit status changes with the improvement of its efficiency. Furthermore, the analysis reveals that financially constrained firm's investment is comparatively more sensitive to its cash flow. Moreover, this sensitivity is statistically significant and is negatively related with corporate efficiency.     

The impact of cash flows and firm size on investment: The international evidence

This paper examines the degree to which cash flow availability influences firm investment in six OECD countries. In particular, we are interested in the extent to which the reliance on internal funds is affected by firm size, since there is general agreement that smaller firms have less access to external capital markets and, thus, should be more affected by the availability of internal funds. Earlier work has concluded that the documented positive relationship between cash flow and investment is evidence of the existence of financial constraints. We first examine all firms, regardless of size, in each country, and we find that the amount of corporate investment is affected by internal resources in all six countries; that is, internal financing affects firm investment. We then repeat the analysis segmenting the sample using three measures of firm size. Contrary to our a priori expectations, we find that the cash flow-investment sensitivity is generally highest in the large firm size group and smallest in the small firm size group. We deduce that the explanations for these findings are grounded in managerial agency considerations, and in the greater flexibility enjoyed by large firms in timing their investments. Thus, we conclude that the degree of sensitivity of a firm's investments to its cash flows cannot be interpreted as an accurate measure of its access to capital markets (as do Kaplan, S., Zingales, L., 1997. The Quarterly Journal of Economics 169–215), since small firms are known to have less access to external markets.     

Ownership structure,cash flow,and capital investment: Evidence from East Asian economies before the financial crisis

Using financial and ownership data from eight East Asian emerging markets before the Asian financial crisis, we document that while the sensitivity of a firm's capital investment to its cash flow decreases as the cash-flow rights of its largest shareholders increase, this sensitivity increases as the degree of the divergence between the control rights and cash-flow rights of the firm's largest shareholders increases. We interpret the results to be consistent with the free cash-flow hypothesis, which postulates that too much free cash flow in the hands of entrenched managers is likely to lead to overinvestment. This is particularly true for firms with the greatest divergence between the largest shareholders' control rights and their cash-flow rights and for firms with lower profitability.     

Underinvestment,capital structure and strategic debt restructuring

This paper shows that shareholders' option to renegotiate debt in a period of financial distress exacerbates Myers' (1977) underinvestment problem at the time of the firm's expansion. This result is a consequence of a higher wealth transfer from shareholders to creditors occurring upon investment in the presence of the option to renegotiate. This additional underinvestment is eliminated by granting creditors the entire bargaining power. In such a case, renegotiation commences at shareholders' bankruptcy trigger so no additional wealth transfer occurs. In addition to deriving the firm's policies, we provide results on the values of corporate claims, the agency cost of debt, and the optimal capital structure. Empirically, we predict, among others, a lower sensitivity of capital investment to shocks to Tobin's q and cash flow for firms financed with renegotiable debt, and a negative effect of debt renegotiability on the relationship between growth opportunities and systematic risk as well as leverage.     

Investment, Uncertainty, and Liquidity

We analyze the dynamic investment decision of a firm subject to an endogenous financing constraint. The threat of future funding shortfalls lowers the value of the firm's timing options and encourages acceleration of investment beyond the first‐best optimal level. As well as highlighting another way by which capital market frictions can distort investment behavior, this result implies that (1) the sensitivity of investment to cash flow can be greatest for high‐liquidity firms and (2) greater uncertainty has an ambiguous effect on investment.     

Morgan Stanley Roundtable on Capital Structure and Payout Policy

A group of finance academics and practitioners discusses a number of topical issues in corporate financial management: Is there such a thing as an optimal, or value‐maximizing, capital structure for a given company? What proportion of a firm's current earnings should be distributed to the firm's shareholders? And under what circumstances should such distributions take the form of stock repurchases rather than dividends? The consensus that emerged was that a company's financing and payout policies should be designed to support its business strategy. For growth companies, the emphasis is on preserving financial fl exibility to carry out the business plan, which means heavy reliance on equity financing and limited payouts. But for companies in mature industries with few major investment opportunities, more aggressive use of debt and higher payouts can add value by reducing taxes and controlling the corporate “free cash flow problem.” Both leveraged financing and cash distributions through dividends and stock buybacks represent a commitment by management to shareholders that the firm's excess cash will not be wasted on projects that produce growth at the expense of profitability. As for the choice between dividends and stock repurchases, dividends appear to provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve a higher degree of managerial fl exibility for companies that want to be able to capitalize on unpredictable investment opportunities. But, as with the debt‐equity decision, there is an optimal level of financial fl exibility; too little can mean lost investment opportunities but too much can lead to overinvestment.     

Concentrating on q and cash flow

Investment spending by US public firms is highly concentrated. The 100 largest spenders account for 60% of total capital expenditures and drive most of the variation in aggregate investment. This high concentration creates a disconnect between the average public firm and macroeconomic aggregates. For large firms, cash flow remains the primary driver of investment spending and has not declined in importance as it has for smaller public firms. The cash flowing to big spenders provides a better forecast of future investment opportunities than noisy proxies for Tobin's q even though these firms are not financially constrained. These results suggest that, at least for the largest spenders, it is unlikely that measurement error drives the significance of cash flow. Our results are also inconsistent with recent models that predict higher investment-cash flow sensitivity for small young growth firms and suggest that cash flow is still the most important determinant of macroeconomic fluctuations in investment spending.     

Financial constraints on credit ratings and cash-flow sensitivity

This study investigates whether financial constraints, as measured by the level of credit ratings and their migrations would affect the firm's cash flow allocation policies and reflect the main financial constraints on a firm's cash flow sensitivity of cash. For a given credit quality shock, control for firm-level characteristics and endogeneity of cash flow allocation, our results suggest that firms with higher credit financial constraints have significantly higher cash flow sensitivities on cash holding, investment, and debt financing activities. Our results provide evidence that credit rating risk has a larger impact on cash flow allocation and drives the financial constraints on cash flow sensitivity for various reasons, including precautionary motivation and restricted access to external financing.     

MORGAN STANLEY ROUNDTABLE ON Capital Structure and Payout Policy

A group of distinguished finance academics and practitioners discuss a number of topical issues in corporate financial management: Is there such a thing as an optimal, or value‐maximizing, capital structure for a given company? What proportion of a firm's current earnings should be distributed to the firm's shareholders? And under what circumstances should such distributions take the form of stock repurchases rather than dividends? The consensus that emerges is that a company's financing and payout policies should be designed to support its business strategy. For growth companies, the emphasis is on preserving financial flexibility to carry out the business plan, which means heavy reliance on equity financing and limited payouts. But for companies in mature industries with few major investment opportunities, more aggressive use of debt and higher payouts can add value both by reducing taxes and controlling the corporate free cash flow problem. In such cases, both leveraged financing and cash distributions through dividends and stock buybacks signal management's commitment to its shareholders that the firm's excess cash will not be wasted on projects that produce low‐return growth that comes at the expense of profitability. As for the choice between dividends and stock repurchases, dividends provide a stronger commitment to pay out excess cash than open market repurchase programs. Stock buybacks, at least of the open market variety, preserve more flexibility for companies that want to be able to capitalize on unpredictable investment opportunities. But, as with the debt‐equity decision, there is an optimal level of financial flexibility: too little can mean lost investment opportunities, but too much can lead to overinvestment.     

Corporate investment,government control,and financing channels: Evidence from China's Listed Companies

We investigate the relation between the internally generated cash flows and fixed asset investments of Chinese firms and find that it is U-shaped. Cash flow and investment are negatively related for low levels of cash flow but positively related for high levels of cash flow. We find that government controlled listed firms have greater investment–cash flow sensitivities than do privately controlled listed companies, especially on the left-hand side of the U-shaped curve where cash flow is negative. However, the difference in sensitivities appears only among firms that possess few profitable investment opportunities. We attribute this finding to the government having multiple socio-economic objectives, which leads to increased capital expenditures by the firms it controls when internal funds are abundant and when internal funds are negative. There is no evidence that access to finance and soft budget constraints explain the differences between the investment–cash flow sensitivities of government controlled and privately controlled listed firms.     

Chaebol-affiliated analysts: Conflicts of interest and market responses

Some Korean business groups, or chaebols, have a large stake in securities firms that issue analysts’ reports on their member companies. This structure is unique in that industrial companies and securities firms are affiliated and operate within the same group. We investigate the informational content of earnings forecasts, stock recommendations and target prices made by the chaebol-affiliated analysts, using data collected between 2000 and 2008. The chaebol analysts tend to make more optimistic earnings forecasts for the member companies. The mean EPS forecast error (5.36%) of the affiliated analysts for the same chaebol company are significantly larger than that (3.23%) of other chaebol and independent analysts. The chaebol analysts also assign better recommendations by almost one level and set target prices 2.5% higher to the member companies after controlling for company and analyst characteristics. These results are consistent with the hypothesis that chaebol analysts’ reports are biased by conflicts of interest. Stock market reactions do not differ in response to announcements of stock recommendations issued by affiliated vs. non-affiliated analysts. This suggests that capital markets do not recognize the conflicts of interest inherent in chaebol analysts’ reports.     

CEO inside debt and investment‐cash flow sensitivity

This paper provides a new explanation for investment‐cash flow sensitivity from the perspective of CEO inside debt holdings. We examine the effect of CEO pensions and deferred compensation (inside debt) on investment‐cash flow sensitivity for a sample of U.S. manufacturing firms from 2006 to 2012. We find that the firms with higher relative CEO leverage ratios (CEO's debt/equity ratio scaled by the firm's debt/equity ratio) generate higher investment‐cash flow sensitivity. Moreover, one standard deviation increase in the logarithm of the relative CEO leverage ratio enlarges investment‐cash flow sensitivity by 50 per cent. This positive relationship still holds even after we take account of endogeneity and financial constraints.     

Emerging Derivatives Markets: The Case of Chile

We compare the performance of firms affiliated with diversified business groups with the performance of unaffiliated firms in Turkey, an emerging market. We address the question of whether group-affiliated firms create internal capital markets or control large cash flows. Our findings indicate that group affiliation improves a firm's accounting performance, but not stock market performance. Deviation of cash-flow rights from voting rights has a negative but insignificant effect on accounting performance, but a significant effect on market performance. We also find that a firm's accounting, but not stock market, performance increases with the level of group diversification. Our results show that internal capital markets play an important role for the existence of business groups in an emerging market context.     

Valuation of Corporate Innovation and the Pricing of Risk in the Biopharmaceutical Industry: The Case of Gilead

Much of a firm's market value derives from expected future growth value rather than from the value of current operations or assets in place. Pharmaceutical companies are good examples of firms where much market value comes from expectations about drugs still in the development “pipeline.” Using a new osteoporosis drug being developed by Gilead Sciences, Inc., the author combines discounted cash flow methods values and real option models to value it. Alone, discounted cash flow (DCF) calculations are vulnerable to the assumptions of growth, cost of capital, and cash flows. But by integrating the real options approach with the DCF technique, one can value a new product in the highly regulated, risky and research‐intensive Biopharmaceutical industry. This article shows how to value a Biopharmaceutical product, tracked from discovery to market launch in a step‐by‐step manner. Improving over early real option models, this framework explicitly captures competition, speed of innovation, risk, financing need, the size of the market potential in valuing corporate innovation using a firm‐specific measure of risk and the industry‐wide value of growth operating cash flows. This framework shows how the risk of corporate innovation, which is not fully captured by the standard valuation models, is priced into the value of a firm's growth opportunity. The DCF approach permits top‐down estimation of the size of the industry‐wide growth opportunity that competing firms must race to capture, while the contingency‐claims technique allows bottom‐up incorporation of the firm's successful R&D investment and the timing of introduction of the new product to market. It also specifically prices the risk of innovation by modeling its two components: the consumer validation of technology and the expert validation of technology. Overall, it estimates the value contribution per share of a new product for the firm.     

Corporate governance in South Korea: the chaebol experience

Utilizing a large sample of South Korean firms, this paper explores the impact of corporate governance in an emerging market country dominated by a few large business groups. Firms affiliated with the top five groups (chaebol) exhibit significantly lower performance and significantly higher sales growth relative to other firms. Furthermore, top executive turnover is unrelated to performance for top chaebol firms, indicating a breakdown of internal corporate governance for the largest business groups. Internal corporate governance appears much more effective for firms unrelated to the top chaebol as managers at poorly performing firms are significantly more likely to lose their job. These results imply that the lack of properly functioning internal corporate governance among the top chaebol, which dominate the Korean economy, may have increased the severity of the recent financial crisis.